Negative Interest Rates Explained

Hi guys, Eddie here with another video. Today we're going to be discussing negative interest rates. So they've been a really hot topic this week, so hopefully I'm going to demystify this concept for you. First of all, I think it's useful to go through the basics. So what is interest? It's essentially the cost of borrowing money, typically expressed as an annual percentage of a loan. So for savers, it's effectively the rate your bank or building society will pay you for borrowing money. So the money you earn on those savings is called interest. Okay, so the interest charged on a loan— so when you borrow money, you pay back the original amount plus interest. Okay, so let's say you borrow £1,000 from a bank. If your loan attracts an interest rate of around 10%, you'll have to pay back £1,000 plus 10%, so £1,100 in total after, let's say, 1 year. Okay, so negative interest rates That means the bank would pay you 10% for taking out a loan, which sounds kind of crazy, right? So bear with me. In terms of the interest rate on savings, so let's say you put £1,000 in a savings account, typically earning, let's say, 2% or 3% if you're lucky, annually. So that will be £20 in interest that you'll receive after 1 year. So let's say £1,020 or something like that. So Negative interest rates for savers means that you will have to pay the bank 2%, so that £20, for keeping £1,000 in the bank account. Sounds crazy, but this is now unfortunately the new reality. So 6 countries currently have— around about 6 countries have a negative deposit rate at the moment. 3 have negative interest rate. Lots of countries as a result of the coronavirus now at that kind of zero lower bound. So The EU and Japan are already negative. Countries like the UK, uh, closer to home, and New Zealand are now pricing in negative rates, uh, as well as the United States, the world's obviously largest, uh, economy. Um, their 2-year gilt for the UK is actually negative already, and central banks have been doing this actually for around 10 years. So look at the Bank of Japan, they are actually the top shareholder in almost 40% of the, uh, publicly traded, uh, companies. So can't shake the feeling. So US policymakers are actually struggling to shake off the notion that interest rates could go negative. So Jerome Powell spoke on Wednesday and said we're absolutely not looking at this as a policy tool, but actually the markets have not reacted to this and basically done what Jerome Powell said, and they're still pricing in now the April 2021 Fed funds futures contract is now pricing in negative rates. The July 2021 contract implied a policy rate of -0.3% on Thursday. Okay, so US rates, are they about to go negative? So Mr. Powell obviously came out on Wednesday. They basically— all the Fed governors came out and said this is not something we're basically looking at. So Sweden, Switzerland, etc., have basically struggled to contain the backlash from banks and savers that have— when they've used negative rates. So this Fed fund futures rate was basically cut to around 0 to 0.25% in an emergency action when the markets, the equity markets sold off around March 23rd. Okay, this sent shockwaves through markets. So you'd think actually, according to economic theory, when you cut interest rates, that's basically cheaper money. Okay, so when you do that, you would expect equity markets to essentially react positively. But actually, the markets basically looked into that kind of announcement and that emergency cut and thought, actually, if the Fed are cutting and loosening and basically cutting to 0% interest rates, they see something really, really bad in the forward-looking data. So this actually led markets to actually sell off. And this is actually something now that if we do have a second wave of this coronavirus, which is looking extra likely at the moment, you know, this notion of negative rates is actually something the Fed are going to struggle to shake off because they are already at that zero bound. They've got no bullets left in the chamber. And Donald Trump is a vocal advocate of negative rates, describing them as a gift to the economy struggling under the weight of something like coronavirus. Who are the winners from something like negative rates? So businesses. So this is essentially cheaper money. So borrowing at low rates will basically decrease their debt servicing costs, their interest payments, and thus hopefully increase profitability. May also lead to more CapEx, so capital expenditures, which in turn may lead to productivity gains in the future. Equities. So for example, when you're valuing a company or an equity, lower rates will actually translate into a lower weighted average cost of capital and should hypothetically increase the present value of the future cash flows, therefore implying a higher implied per-share value. For mortgage owners, this is also good news. So people, uh, around the country may be living in houses like on the slide. Floating rate mortgages, uh, payments will actually decrease. So this will increase discretionary income, and it will also be cheaper to actually get a mortgage. Exporters— so let's say UK companies that do a huge amount of their revenue are actually exporting their goods— the currency, as a result of a loosening of financial conditions in terms of lowering interest rates, should theoretically— the currency should fall in response. This is because capital will flow out from the UK, as an example, into other countries with higher interest rates or higher yields. So this is good for exporters because their goods are now more attractive to foreign importers as a result of that FX impact. Let's look at the losers from negative interest rates. Banks, lower rates actually puts pressure on their net interest margins. This is the difference between what they borrow at and lend at. Lowering their bank's profitability, this will actually punish banks from parking money at central banks. This will actually hypothetically encourage them to lend, which is not actually the consensus view of what we've seen in countries like Japan, uh, and Europe. So the savings rate, uh, is essentially where obviously individuals keep their money. This will be slashed even further than it already has. So savers actually may move money out of their savings account and actually hunt for yield in more riskier assets like equities. So if you're an unsophisticated investor, this could lead to severe capital losses. So there is evidence that the European Central Bank's -0.5% interest rate has eaten into banks' profits, and the policy could have a similar effect elsewhere. In fact, while average mortgage rates have been falling to all-time lows, some lenders have been raising their rates because they've been overwhelmed by the loan requests, particularly from homeowners eager to refinance and save. Negative rates, as for a kind of upside for banks, would bail out the small banks, but for savers, this is essentially a tax on your savings. So a Bank of America strategist came out Mark Cabana said, I think it would be very negative connotation to have a saver who has worked so hard to make money and wants to try and be prudent by saving it, that to then be taxed on that. When you think about like that, it's absolute madness. So let's have a look at the bank's hedging. So essentially, investors and analysts, uh, furthering on to the point that I discussed earlier in the video, unwilling to rule out the possibility of negative rates. And this is despite obviously Jerome Powell and all the Fed governors essentially coming out. So banks have actually been hedging, and some of the world's largest banks have been hedging their US kind of rate volatility. And this actually sparked a flurry of concern that the Fed could cut interest rates below zero for the first time. So the rates are on the, basically, the Fed fund futures, and these are, this is a key tool for investors seeking to bet or hedge against interest rate shifts. And this popped above 100 last week. This is a signal from the market that essentially the negative policy rates are on their way. But this has actually been pushed back by some senior traders active in the market saying few funds or banks are actually betting on the Fed following peers in Europe, in Japan to negative rates. So instead, some banks are actually trying to protect themselves and their clients against this high risk take. So this is something called tail risk. And this stems in part from swaps contracts. So this is basically a tool that Wall Street uses to provide companies enabling their clients to swap a stream of floating rate payments in exchange for a fixed rate payment. And this is to basically shield them from the volatility in the benchmark interest rates. So in a vicious cycle, the more hedging that goes on through the market, the stronger, stronger those expectations for negative rates actually become. So these Fed fund futures markets are not that deep. So one or two really large banks, when they kind of start to execute these trades, that's enough to start pushing things. And once that started, senior bankers from all over the world have said they're getting loads of calls regarding if rates are going to go negative, and it almost becomes its own self-fulfilling prophecy. So this is something that is a kind of strategy of mine, or something that I believe that will happen. So Powell has kind of shown his hand. So if you flash back all the way to March, we had essentially an artificial tightening of financial conditions. And this is essentially where the market pricing was tighter than what the Fed funds futures or the Fed funds rate was actually at. And this actually tightens financial conditions artificially. So if markets were going to have another sell-off, this could prove and test the Fed's resolve. So what happened in March essentially is equity markets sold off and this actually reduced the pricing in terms of the interest rate, the market was pricing for lower rates or lower than the Fed funds futures, the Fed funds rate was actually at. So if that Fed rate stays above the market pricing, this tightens financial conditions. So if we see, um, another kind of equity sell-off, we're going to see the markets dramatically pricing, uh, for this lower interest rate. Okay, and if that stays above the Fed, the Fed funds rate stays above that, that's an artificial tightening of conditions. And Bank of America have actually come out and said negative of US rates could lead to a retest of stock markets. And again, this is that signaling from the, from the Federal Reserve that the markets just do not like. So I hope this video was useful. If you haven't already, subscribe to the channel, turn on post notifications, and you'll be alerted when there's any other video like this from myself, Anthony Cheung, Will, or Sam coming with a technical analysis on Sunday night. Take care, have a lovely weekend, and I hope you enjoyed.